Analysis and criticism of America's most prominent public intellectual and champion of Keynesian economics. I am part of the Austrian School of Economics, and I critique Krugman's writings from that perspective.

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Friday, April 30, 2010

In his best-seller, The Return of Depression Economics (which I am having my MBA students read this spring), Paul Krugman declared that most economic problems can be "solved" rather easily: the government prints more money. I am not making up that declaration, nor am I embellishing it or putting it out of context. That is what he said, and, like Sgt. Friday, just the facts, ma'am.

Today, he looks once again at the crisis in Greece, which has spread to Spain and where Austrians see fiscal folly and wages and work policies that are totally out of line with the structures of production in those country, a situation that must be put back into balance to end the crisis, Krugman sees the lack of inflation being at fault. Don't take my word for it. Read on:

The fact is that three years ago none of the countries now in or near crisis seemed to be in deep fiscal trouble. Even Greece’s 2007 budget deficit was no higher, as a share of G.D.P., than the deficits the United States ran in the mid-1980s (morning in America!), while Spain actually ran a surplus. And all of the countries were attracting large inflows of foreign capital, largely because markets believed that membership in the euro zone made Greek, Portuguese and Spanish bonds safe investments.

Then came the global financial crisis. Those inflows of capital dried up; revenues plunged and deficits soared; and membership in the euro, which had encouraged markets to love the crisis countries not wisely but too well, turned into a trap.

What’s the nature of the trap? During the years of easy money, wages and prices in the crisis countries rose much faster than in the rest of Europe. Now that the money is no longer rolling in, those countries need to get costs back in line.

But that’s a much harder thing to do now than it was when each European nation had its own currency. Back then, costs could be brought in line by adjusting exchange rates — e.g., Greece could cut its wages relative to German wages simply by reducing the value of the drachma in terms of Deutsche marks. Now that Greece and Germany share the same currency, however, the only way to reduce Greek relative costs is through some combination of German inflation and Greek deflation. And since Germany won’t accept inflation, deflation it is.

Krugman, of course, supports Germany having a round of inflation. We have been down this road before, people, and it ends in disaster. In the late 1920s, Great Britain did not want to devalue the Pound, which at that time should have been trading at about $3.50 instead of the $4.86 "official" rate.

To keep the $4.86 rate intact, Benjamin Strong, who then was the chairman of the New York Federal Reserve Bank, cut a deal with Montagu Norman, Britain's equivalent of the Secretary of the Treasury, to inflate the U.S. Dollar. This led to the infamous stock market bubble that burst in October, 1929, and President Hoover's response to that crash (to try to prop up failing firms, as well as prop up high prices and wages) led to the Great Depression.

The Germans have their own history with inflation (1923 anyone?) and are not about to go the Benjamin Strong route, as to do so would create a series of troubles down the road. Unfortunately, inflation ultimately distorts an economy's structure of production, leads to unsustainable booms, and then to disaster. However, Keynesians like Krugman hold that the Very Worst Thing that can happen to an economy is deflation, and that prosperity is possible only through inflation.

Here is the problem with Krugman's prescription (Germany inflate, Greece continue as is): It does nothing to get the Greek fundamentals back into order and it distorts the economic fundamentals in Germany. In other words, it does nothing to solve the real, underlying problems in Greece, but it lays the foundation for a future crisis in Germany, as inflation will create its own problems.

If you wish to see an important difference between Austrians and Keynesians, here it is. Keynesians really don't see economic fundamentals, nor do they see any issues with factors of production. Instead, in their view, the economy is a homogeneous mix that works when government throws lots of money into the recipe. If there are imbalances (and the theory does not allow for that to happen, although Krugman himself recognizes that imbalances could be an issue), then inflation can solve everything. Unfortunately, what happens when governments engage in policies of inflation is that the seeming good effects come first, but then when the factor prices get out of balance with what is being produced, the economy moves toward an inevitable bust, and any attempts to "fix" things through another round of inflation only make things worse.

Austrians, on the other hand, look first at the factors of production for the distortions in the entire structure of the economy. Deflation, far from being the enemy of the economy, allows those factors to get back into balance with the overall structure of production, and direct production to consumer desires. It is the opposite of inflation: the bad effects come first (unemployment and initial dislocation), but the "good" effects come later (a recovery).

There is no way to bridge the gap between Keynesians and Austrians. Today, it is the Keynesians that rule, and it is economy that ultimately will suffer because their "theories" ultimately lead to disaster.

No, Greece cannot "solve" anything by going back to the Drachma and printing out the wazoo. Instead, it is up to that country to get its house back in order by letting the factors, including labor, get back into balance. That means, in the initial stages, that Greeks will find their wages being cut and their standard of living will fall. Yet, that initial stage is absolutely necessary if, in the long run, Greeks want to enjoy a higher standard of living in the future with an economy that is sustainable.

[Note]: It is good to be posting here again. I have been following the Tonya Craft trial in Ringgold, Georgia, and it is a fiasco. The prosecutors are running the show, and they are acting like typical high school bullies. It is a tragedy and a train wreck in progress.

Monday, April 26, 2010

In his column today, Paul Krugman takes on the Rating Agencies, such as Moody's, that were giving AAA marks to sub-prime debt that turned toxic. His comments here are on the mark:

Let’s hear it for the Senate’s Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.

That’s the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.

No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.

What those e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.

He is right about the out-and-out whoredom of the agencies and I also agree that Financial Reform as is being touted right now would not solve the problem.

The issue, however, is why the once-staid and sober Moody's and Standard & Poors turned into a bunch of financial drunkards in a relatively short period of time. That is where Krugman and I differ.

As an economist, when I see something perverse like what happened, I look for the underlying reasons, and especially the structure of incentives that helped bring about this whole regime change in how the agencies went about their business. While I am sure Krugman gives lip service to incentives, he prefers the Keynesian line about "deregulation," which tends to be the ideological umbrella under which he works.

A friend of mine who is a first-rate accountant said that mortgage bankers told her that what seemed absolutely silly and reckless after the bust made perfect sense when the easy money regime was ruling. This is vital to understanding the boom-and-bust, as Austrian Economists point to the actions of the Federal Reserve System holding down interest rates and flooding the markets with credit.

Now, Krugman at the end does give lip service to incentives, but he still misses the bigger picture. Had the Fed not been reckless with interest rates and dumping credit everywhere, the incentives for the ratings industries would have been different, period. As Peter Schiff said last year, "The whole country was drunk." The real question, he asks, is who brought the booze.

This is where Krugman and the Austrians differ. We believe that if the Fed is not playing the credit sugar daddy, the incentives that run with an easy money financial regime will not be there. (This is not excusing Moody's and S&P for not doing their jobs, but rather giving a reason as to why they took flight from sound finance.)

Krugman, on the other hand, believes that the Fed should continue providing the liquor, but the regulators will tell Wall Street when, where, and how much to drink. This is a recipe for later problems that will be worse than what we are facing now.

Sunday, April 25, 2010

I have not made as many posts as usual here at KIW because I have been intensely following the trial of Tonya Craft at my other blog. She is being tried for allegedly molesting three young girls, including her daughter.

However, as I follow the trial and how it came about, it has become utterly obvious to me that this is a sham. The "investigators" who supposedly interviewed these children were absolutely unqualified and in most states would not be permitted to testify as expert witnesses at all. Furthermore, if one remembers the infamous child molestation hoaxes that swept this country about 20 years ago, causing untold human destruction, as well as the Duke Lacrosse hoax of four years ago, you will then understand the dynamics of this particular trial.

I have been writing on this case for a couple of weeks, and I will admit that it is taking huge blocks of time, not to mention emotion and about everything else. Yet, I believe it is important, because what we are seeing is state-sponsored judicial terrorism at work. The State of Georgia has been suborning perjury, prosecution witnesses on the stand SUDDENLY REMEMBER all sorts of damaging things that they conveniently had "forgotten" to tell investigators before the trial began.

This memory "recovery" has happened time and again and it occurs because the judge, Brian House, and the prosecutors, Chris Arnt and Len Gregor, have encouraged it. What people are witnessing is a crooked trial, and it is happening in real time.

So, while it is going on, I won't be making as many posts here at KIW, even though I know Paul Krugman will be saying outrageous things that should be answered. Nonetheless, I hope all of you will bear with me. Thanks.

It always is frustrating in reading a Krugman column which begins with promise, as I don't want to be opposing the guy just to oppose him. Rather, I wish to oppose his arguments. For example, a few years ago, he was (appropriately) knocking down the so-called lump-of-labor fallacy that holds there are only a finite number of jobs in any economy, so they have to be spread out. (Union work rules arise from this theory, which is why we often see some ridiculous work arrangements in union contracts.)

As I was reading the column, I was agreeing wholeheartedly. Unfortunately, he ended with his usual non sequitur. He claimed that by not "fully funding" the Homeland Security Department(!), the Bush administration was falling to the "lump-of-labor" nonsense, leaving me with a "Huh?" response.

Likewise, today he begins by saying the following:

On Thursday, President Obama went to Manhattan, where he urged an audience drawn largely from Wall Street to back financial reform. “I believe,” he declared, “that these reforms are, in the end, not only in the best interest of our country, but in the best interest of the financial sector.”

Well, I wish he hadn’t said that — and not just because he really needs, as a political matter, to take a populist stance, to put some public distance between himself and the bankers. The fact is that Mr. Obama should be trying to do what’s right for the country — full stop. If doing so hurts the bankers, that’s O.K.

More than that, reform actually should hurt the bankers. A growing body of analysis suggests that an oversized financial industry is hurting the broader economy. Shrinking that oversized industry won’t make Wall Street happy, but what’s bad for Wall Street would be good for America.

At one level, he is correct. Wall Street DOES need reform, and it cannot be business as usual for the Usual Suspects. That being said, however, we need to remember that two years ago, the market was saying the following in no uncertain terms: "You bankers have had a wonderful run, with your bonuses and your big houses in Connecticut. It is time to say goodbye to all of that and live in the real world again."

However, being that Krugman believes the market always is bad, he called for bailouts and then demanded "reform." And, once again, we see that Krugman recognizes the disease, but then calls for a "cure" similar to bloodletting or pouring arsenic down the patient's throat.

There are two ways to travel here. The first way is what Krugman and others are demanding: Have essentially a state-run financial system in which the SEC controls ALL of the investment sectors, with the supposed "brilliant" regulators knowing exactly what investments to choose. Yes, I guess Krugman means people like this, which apparently populate that august regulatory agency known as the SEC:

As the country was sinking into its worst financial crisis in more than 70 years, Security and Exchange Commission employees and contractors cruised porn sites and viewed sexually explicit pictures using government computers, according to an agency report obtained by CNN.

"During the past five years, the SEC OIG (Office of Inspector General) substantiated that 33 SEC employees and or contractors violated Commission rules and policies, as well as the government-wide Standards of Ethical Conduct, by viewing pornographic, sexually explicit or sexually suggestive images using government computer resources and official time," said a summary of the investigation by the inspector general's office.

More than half of the workers made between $99,000 and $223,000. All the cases took place over the past five years.

My guess is that Krugman would claim that these people did not "believe in government."

There is another way, and that is to make these firms accountable to the market for their actions. Yes, there is moral hazard created in the markets and, yes, people scratch each others' backs, but that also goes on in government, and I would defy Krugman to create a government agency that ultimately does not become yet another example of how "Capture Theory" works.

As Peter Schiff noted in this speech (yes, I repeat stuff from an earlier post), the market would have caught onto Bernie Madoff long before the SEC had figured out the scam, but because the SEC was putting its bill of approval on Madoff's secret Ponzi operation, he went undetected until the whole thing fell down.

Are we going to have that kind of Wall Street, a financial system in which individuals actually are accountable to their errors? Not at all. The irony, however, is that Krugman believes that by creating a Bigger Financial Cartel, he is going to get the moral hazard out of the system. Right.

Of course, Krugman also believes that the Federal Reserve System has "saved" our economy when, in fact, it is making it even more unstable and vulnerable to future meltdowns. Unfortunately, a nanny-state liberal like Krugman simply cannot bring himself to believe that government run by People Who Think Like Him actually can run an economy -- instead of running it into the ground.

Thursday, April 22, 2010

When I was in graduate school, one of my professors told me that he believed that Ludwig von Mises was a "first-rate mind," and that Paul Samuelson had a "second-rate mind," but that Samuelson had captivated the mainstream. Certainly, Paul Krugman's near-worshipful tribute to Samuelson confirms that even though Keynesian "economics" is a fraud, the fact that Samuelson helped establish it in U.S. academe makes him an icon.

Here is what another economist, a man who not only has been prominent in economic circles but is, in my view, a much better economist than Krugman ever could be, has to say about Samuelson and Krugman's remarks:

Samuelson 1948 still the standard we need today. Pathetic.

Krugman thinks Samuelson's merely playing with ideas, as opposed to seeking the (closest attainable approximation of the) truth, was a virtue. To me it was a fatal flaw. He was very, very clever, in the way that a really bright boy can solve all sorts of mathematical puzzles without knowing anything at all about how the real world works.

Wednesday, April 21, 2010

In an earlier post, I wrote that Paul Krugman is basing a lot of his policy analysis upon the belief that future Wall Street bailouts are inevitable. Given what has transpired in the past few decades, I would say that he very well might have a point.

Thus, by beginning with the assumption that there will be bailouts, Krugman then mentally reconstructs a financial system that will never need to be bailed out, or where bailouts where be rare. How would such a system be organized, and what would it do?

While Krugman has not put out a hugely-detailed plan, some things clearly are in view. First, all of the financial organizations, including banks and the financial houses such a Goldman-Sachs, would be strictly regulated by the SEC. (However, the SEC currently regulates these institutions, so my guess is that what he proposes is that the SEC be given more power than it currently has, the idea being that more regulation will keep meltdowns from occurring.)

On the other hand, as noted in earlier posts, Krugman also favors the Fed aggressively lowering interest rates to below-market levels, which not only would be inflationary but would discourage savings. (Of course, Krugman, being a good Keynesian, attacks savings as lowering "aggregate demand.") So, we have the prospect of the Fed opening the money spigots and the SEC trying to route it to "safe" investments.

In a speech last year, Peter Schiff pointed out that depending upon the SEC to vet all firms actually creates larger problems because market participants are not as careful about their choices. He gave the example of con artist Bernie Madoff, noting that had people not been fooled by the lack of SEC oversight, the market would have flushed out Madoff long before his empire fell.

I think Schiff is on to something here. Krugman seems to believe that since bailouts are inevitable, we need a very strict SEC to vet everything, and a Fed to turn up the crank, and somehow that will give us prosperity -- and will keep bailouts from ever being reality. All that is needed, he claims, is for regulators to be "smart" and "believe in government."

What Krugman does not say is that having the federal bureaucracy determine the direction of investing will be disastrous. Do we really want the risk-averse, bureaucratic culture to run our economy, because THAT is what would happen.

I have a better idea. Require banks to hold 100 percent reserves and tell all financial firms that if they fail, they fail on their own. Unfortunately, our current political culture favors bailouts, and if that culture continues, we are going to find that "finance" will mean nothing more than borrowing and paying off government debt.

Tuesday, April 20, 2010

Most of the economists I have known have been associated loosely with the Republican Party or maybe the Libertarians. (Mark Thornton and John Sophocleus, two of my favorite economists and writers, both ran for statewide offices in Alabama as Libertarians, and both did better than most other Libertarian candidates have done. Neither are kind to the Republican Party.)

That being said, I never have dealt with any economists that were hyper-partisan Republicans, and at most economic events dominated by my friends, I heard more criticism of Republicans than I heard praise. Then there is Paul Krugman.

Even though the Republicans are nearly endangered species in this Congress, Krugman still insists that they are like Goldstein, falsely convincing us that we are at war with Eurasia when, in reality, we are at war with East Asia. For example, as I have pointed out many times before, he continues to claim that it was Reagan and the Republicans that gave us financial deregulation when the most important deregulation bill, DIDMCA, was passed in 1980 when Jimmy Carter was president and Democrats had the same majority in the Senate and an even bigger one in the House.

So, I hardly am surprised when Krugman insists that Goldstein, er, the Republicans, might kill the present "financial reform" bill. Now, if this is anything like the "reform" that gave us Sarbanes-Oxley or the Patriot Act that "reformed" how the government conspires against its citizens, then I am not sure I am in the market for such an act and would cheer on anyone willing to filibuster it.

Krugman writes:

I have a theory about the problem here. My understanding is that Obama officials have looked at the polls, which show that the public overwhelmingly favors cracking down on Wall Street; so they assumed that the GOP wouldn’t dare stand in the way. But they seem not to have learned, even now, that the right has an awesome ability to create its own reality: that Mitch McConnell et al would stand in the way of reform while claiming to be taking a stand against Wall Street.

that is a most interesting theory, actually. Now, what does he mean by "cracking down" on Wall Street? What he means is that Wall Street becomes the repository for buying government bonds (after the Chinese decide they don't want any more of that junk).

Furthermore, what he wants is to create what essentially would be a large financial cartel held together by the wise regulators from the SEC (who, on application, would have to pledge that they, like Krugman, "believe in government"). I doubt Krugman will use the "C"-word, but that is what he wants, and he forgets that the last SEC-run financial cartel fell apart about 1980, whether or not he wants to believe it. Furthermore, if he believes that giving the Federal Reserve System even more power than it has now is "reform," well, Lucy van Pelt has a football she wants you to kick.

Of course, he could not resist hinting that not falling into line with his view of "reform" is racist. In his own words:

And let’s be clear: there’s a sort of tribal thing going on (and I don’t necessarily mean race, although that’s part of it). The hard right has managed to convince a large number of Americans that it consists of people like them, whereas progressives are alien and untrustworthy; in the face of that, rational arguments don’t make much of a dent.

That the "Progressives" are our friends reminds me of the scene in "The Unbearable Lightness of Being" in which dissidents are being interrogated after the Soviet crushing of the Prague Spring, with the interrogator shouting, "Don't you know that we love you?!?

Monday, April 19, 2010

With the SEC's recent filing against Goldman-Sachs, it looks as though the government is doing its best to deflect attention from its own role in the financial meltdown while blaming it on everyone who attended the drunken party, while failing to include the Federal Reserve System, which was the main supplier of the financial alcohol.

As I have said before, there is plenty of blame to go around. Wall Street executives were not exactly refusing to put the Fed's alcohol in the punchbowl and did everything possible to encourage the whole country to partake. Unfortunately, unless we get to the most important lesson -- that the Fed played the most important single role in creating the meltdown -- then we really are going to living in a repeat of "Groundhog Day."

In his column today, Paul Krugman repeats the tired canard that it was a lack of regulation that created the conditions for the meltdown. The capitalists were greedy, and the Bush administration -- lovers of free markets all -- simply stood by while the system went to hell. Furthermore, as the SEC alleges, it seems that some firms actually were shorting mortgage securities while, at the same time, promoting them. (Investors call it a "straddle," and it is common practice for people who trade in options.)

Krugman asks:

So what role did fraud play in the financial crisis? Neither predatory lending nor the selling of mortgages on false pretenses caused the crisis. But they surely made it worse, both by helping to inflate the housing bubble and by creating a pool of assets guaranteed to turn into toxic waste once the bubble burst.

As readers know, I tend to be much more skeptical about allegations of fraud, simply because I have seen federal prosecutors use the term too many times and clearly in situations in which no one intended to engage in what traditionally is known as deception. I'm not going to say that real-live criminal fraud does not exist on Wall Street or that there were fraudsters in the mix before the meltdown.

However, it is easy to dismiss everyone as a crook instead of understanding that the biggest engine of fraud on Wall Street was not Goldman-Sachs, as bad as the firm might be. No, it was the Fed.

Krugman and I both agree that the housing boom and all that it entailed was not sustainable. (Although, there is nothing in the Keynesian theory that says a boom, even a housing boom, cannot go on forever, just as long as government provides the money.) We even agree that the Fed was holding down interest rates.

But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance.

In other words, after the Fed brings the liquor to the party, it then will effectively regulate its consumption. However, cheap money carves its own trails.

There is another point. Krugman goes off on a number of derivatives and swaps, but he forgets that the underlying reason Wall Street could do this was because the Fed was showering The Street with easy money. You cannot have an easy money regime AND sound investments. It just won't happen.

I have been following a very disturbing trial in North Georgia (where I lived for many years) in which a kindergarten teacher named Tonya Craft is being tried on charges of child molestation. The facts simply don't add up and it is becoming obvious that this is another rendition of the day care sex abuse hysteria that swept the country a couple decades ago.

I'm convinced that this is a railroad job on the level of the infamous Duke Lacrosse case of four years ago, and I am doing some investigation on my own. I'll try to get a post dealing with Paul Krugman's column today, but right now, my mind is in North Georgia.

Saturday, April 17, 2010

Poor, Paul Krugman. Though he might try to rid his vision of those horrible people who refuse to share his worldview, alas, he is forced at times to eat with the Great Unwashed:

I just had dinner in DC with a bunch of geographers, at a cute French bistro near Dupont Circle. And who should walk in but about eight tea partiers, still carrying their protest signs. They marched in, then upstairs, and sat down for dinner.

Presumably their steak frites came with freedom fries.

Oh, and based on casual observation, every member of the group was on Social Security and Medicare. I guess they’re determined not to let the government get its hands on either program.

No doubt, Krugman will be a happy camper when those supposedly non-existent, money-saving Death Panels take care of those dissidents.

Friday, April 16, 2010

Keynesians are nothing if not versatile. Until ObamaCare was signed into law, Paul Krugman was a "healthcare" economist (which really is a person with a Ph.D. in economics who believes that government can work magic through coercion in doling out medical care).

However, at this time, Krugman now is foremost a "financial" economist, which means a person with a Ph.D. in economics who believes that government can run the nation's financial system with brilliance and efficiency. Yes, yes, I know that there is this problem with the government's accounting methods (although Krugman believes that government under Democrats, no matter how fraudulent its accounting methods, still is magic), but Krugman being a True Believer thinks that government regulators are omniscient (if they are "smart" and they "believe in government") and can get past the problems that would bedevil most mortals.

In his Friday, April 16, column, Krugman repeats his usual tricks of rewriting history and then claiming that all that is needed to "save" the financial system is to bring back the financial cartels that dominated U.S. finance from the New Deal until the early 1980s. Of course, that means his methods are utterly predictable: claim that Republicans want financial failure and then blame Ronald Reagan for everything. In other words, truth really does not matter.

Before going further, let me emphasize that I have no faith in whatever Republicans are promoting in Congress. When they were in power, they used Wall Street like their own private piggy bank, and it blew up in their faces. Nonetheless, while I don't trust them in power, I do find that at least some of the rhetoric they are using now actually has some truth in it.

In likening Sen. Mitch McConnell's arguments against provisions in the Democrats' plan to calling for the abolishing of fire departments, Krugman writes:

In his speech, Mr. McConnell seemed to be saying that in the future, the U.S. government should just let banks fail. We “must put an end to taxpayer funded bailouts for Wall Street banks.” What’s wrong with that?

The answer is that letting banks fail — as opposed to seizing and restructuring them — is a bad idea for the same reason that it’s a bad idea to stand aside while an urban office building burns. In both cases, the damage has a tendency to spread. In 1930, U.S. officials stood aside as banks failed; the result was the Great Depression. In 2008, they stood aside as Lehman Brothers imploded; within days, credit markets had frozen and we were staring into the economic abyss.

There he goes again, parroting the Wall Street line that "we let Lehman fail and then look what happened after that." I hate to say it, folks, but had the Bush administration "saved" Lehman, we still would have had a huge mess. It was not the failure of Lehman per se that created the temporary Big Freeze on Wall Street, but rather the hard fact that the entire financial industry was infected by the toxic mortgage securities that had become the basis for a lot of financial pyramid schemes.

Likewise, had the Hoover administration and the Federal Reserve System "saved" the banks by flooding them with newly-printed money, as Krugman insists should have been the case, the economy still would have imploded. The problem was not lack of action by the federal government, but rather that the financial system that was undergirded by the Fed was inherently unstable. Furthermore, the new regulation initiatives pushed by Krugman and the Democrats really does not address the larger problem that comes when banks are permitted to engage in something akin to Bernie Madoff's Ponzi fraud.

(In this wonderful speech in which he addresses a number of issues Krugman has raised, Peter Schiff says, tongue-in-cheek, that given Madoff's financial practices, he should have been made Secretary of the Treasury.)

Instead, Krugman envisions a regulatory scheme that is a repeat of what existed before 1980, but now brings the brokerage houses and investment banks into the mix:

Since the 1930s, we’ve had a standard procedure for dealing with failing banks: the Federal Deposit Insurance Corporation has the right to seize a bank that’s on the brink, protecting its depositors while cleaning out the stockholders. In the crisis of 2008, however, it became clear that this procedure wasn’t up to dealing with complex modern financial institutions like Lehman or Citigroup.

So proposed reform legislation gives regulators “resolution authority,” which basically means giving them the ability to deal with the likes of Lehman in much the same way that the F.D.I.C. deals with conventional banks. Who could object to that?

Well, I would object to it for the very reason that I believe that what we would have would be just a larger cartel, but a cartel that would behave exactly the way that cartels behave: cut back production, fund projects that are politically, not economically viable, and make sure there is no financial innovation in the system. Furthermore, the scheme Krugman is pushing does nothing to eliminate the moral hazard in the system, and he knows it. His solution? Let the regulators decide what should be financed, as they always make the right decisions (if they are Democrats, are "smart" and "believe in government.")

Of course, there is the obligatory slap at Reagan, claiming that it was he who gave us financial deregulation when, in fact, the major initiatives began when Jimmy Carter was president and the Democrats enjoyed larger majorities in Congress than they have now. That is the hyper-partisan Krugman at work, but it is falsification of the historical record, and deliberate falsification at that.

Now, Krugman is correct. We can have financial cartels and they will be relatively stable -- at least for a while -- but because the man has absolutely no knowledge of regulation (except he believes in it, provided regulators are Democrats, are "smart" and "believe in government") and apparently knows nothing about the huge volume of academic and popular literature on what really happens in regulatory schemes, he gets it wrong in the end.

The banking cartel whose passing he laments did not come to an end because Ronald Reagan dreamed of free markets. It ended because that cartel could not and would not finance a number of new entrepreneurial initiatives that have marked our economy for the last 30 years. Much of what has driven modern life, from telecommunications to computers to discount retailing came about because these initiatives were financed outside the banking cartel. The pressure to "let the banks compete" came not from Reagan but from the bankers themselves, along with Democrats like Alfred Kahn, who saw the real limitations that the New Deal-era regulations were imposing upon the economy.

Unfortunately, Krugman wants us to forget that in 1980 -- before Reagan even received the Republican nomination for president -- the economy was suffering from high unemployment AND double-digit inflation. Banks were losing capital because of the regulatory restrictions, and we had government-created and enforced cartels in railroads, trucking, finance and telecommunications. It was the Democrats that saw the problems this regime was creating and worked to do something about them.

As always happens in the political realm, the deregulation initiatives turned into schemes to help finance politicians, and whenever an industry, like high-tech, did not give enough political contributions, Congress encouraged anti-trust authorities to move in and make threats, as what happened in the Microsoft prosecutions of the late 1990s. Krugman really does not recognize that situation, nor do I believe that he is capable of understanding it, as his hyper-partisan ideology and his Keynesianism prevent him from absorbing an education in simple economics.

Thus, Krugman's "solution" is just to create an even larger cartel by bringing in the politically-connected brokerage houses and investment banks, but that just is setting up the economy for another crisis, just like what we had in 1980. Krugman, however, does not worry about that problem. Like the economist stranded on a desert island who decided to "assume" a feast was spread before him, Krugman simply "assumes" that government-created cartels will solve all of our economic problems. History tells us something different, but that does not matter. Krugman "assumes" a different history than what really happened.

Back in early 2009 I was skeptical about the ability of major banks to recapitalize themselves out of profits. I was wrong, it turns out. Here’s why: Financial-industry profits have soared, probably because banks that can borrow money cheaply — because they have an implicit guarantee from the feds — are more or less guaranteed money machines unless they do something stupid; and gross stupidity has been placed temporarily on hold.

This has been good for the TARP, which won’t lose much money.

Beyond that, however, I find this ominous. We got into this mess because we had an over-financialized economy, with finance making a share of profits out of all proportion to its actual economic contribution. And now it’s baaaack.

If Krugman were to talk to the Austrian Economists -- a group he holds in total contempt -- he might find that the better road would have been for there to be no TARP at all.

The very best thing that could have happened to Wall Street, which was exposed by the free market for being over-leveraged and its executives overpaid, would have been to let some people besides Lehman go out of business. As Peter Schiff asked in a great speech last year, "Why do we need Goldman Sachs?" Indeed, why do we need a lot of the very players with the Ivy League pedigrees who brought down our economy, yet made a bundle in the process?

Instead, we now have the same people even more politically entrenched than before, who understand that beyond all else, as long as they give political contributions and agree to appear at a D.C. show trial or two, they have free reign for as long as they want. It's a great deal for them, but lousy for everyone else.

Krugman seems to understand that point instinctively, but because he apparently does not believe in the established "Capture Theory" of Regulation, he is not going to understand why the regulatory regime that he wants exists only in his imagination.

Wednesday, April 14, 2010

In a recent post on his blog, "Paging Larry Kudlow," Paul Krugman quotes from something Larry Kudlow wrote in 2007:

I have long believed that stock markets are the best barometer of the health, wealth and security of a nation. And today’s stock market message is an unmistakable vote of confidence for the president.

Krugman then posts the following graph showing the recent trends of the Dow:

However, it seems to me that Krugman is working against himself, for if the Dow in 2007 was not predicting the meltdown of 2008, then why should we believe it today as a predictor of the future, given President Barack Obama's policies? Krugman cannot have it both ways, but, alas, that is what he wants.

Now, Kudlow hardly is credible, in my view, for he publicly disagreed with Peter Schiff a few years ago, and he DID tell the Fed in about 2003 to "pour it on," meaning that it should print money like mad, which it did. We saw the results.

Monday, April 12, 2010

In the past, I have said that Paul Krugman is a one-trick pony: his answer to everything is for the government to print more dollars. Indeed, in a recent article, Peter Schiff took apart Krugman's rewriting of U.S. financial history, noting that after World War II, contra Krugman, the U.S. Government reduced expenditures. (Burton Folsom in this article notes that, contra Krugman, the post-WWII U.S. Government also cut tax rates across-the-board, which Krugman considers to be a Great Sin.)

Writing about the high rate of bank failures in Georgia, compared to the relative stability in Texas, Krugman writes that in most cases, the high rates of foreclosures tended to be concentrated in areas with strict zoning laws. He writes:

To appreciate Georgia’s specialness, you need to realize that the housing bubble was a geographically uneven affair. Basically, prices rose sharply only where zoning restrictions and other factors limited the construction of new houses. In the rest of the country — what I once dubbed Flatland — permissive zoning and abundant land make it easy to increase the housing supply, a situation that prevented big price increases and therefore prevented a serious bubble.

Now, this would seem to be a case of the Law of Unintended Consequences rearing its head, since all good "Liberals" like Krugman are staunch supporters of strict zoning laws, but that fact seems to have escaped the Nobel Prize laureate. Instead, Krugman claims that he has found the magic bullet that tells us why Texas does not have the same kind of banking crisis that has hit Georgia:

So what’s the matter with Georgia? As I said, banks went wild, in a scene strongly reminiscent of the savings-and-loan excesses of the 1980s. High-flying bank executives aggressively expanded lending — and paid themselves lavishly — while relying heavily on “hot money” raised from outside investors rather than on their own depositors.

It was fun while it lasted. Then the music stopped.

Why didn’t the same thing happen in Texas? The most likely answer, surprisingly, is that Texas had strong consumer-protection regulation. In particular, Texas law made it difficult for homeowners to treat their homes as piggybanks, extracting cash by increasing the size of their mortgages. Georgia lacked any similar protections (and the Bush administration blocked the state’s efforts to restrict subprime lending directly). And Georgia suffered from the difference.

It is hard to examine this point in a short column, and I don't know how much Georgia's banking laws differ from those in Texas, although the ultimate irony to me is that George W. Bush was governor of Texas before coming to the White House, which, according to Krugman, generally makes that state to be evil. Nonetheless, I will take Krugman's word for it that Texas has stricter banking regulations than does Georgia (although the devil always is in the details and I suspect that the differences between Georgia and Texas are more cloudy than what Krugman tells us).

Thus, Krugman, reasons, the key to financial reform is regulation:

So what’s the moral of this story? As I see it, it’s a caution against silver-bullet views of reform, the idea that cracking down on just one thing — in particular, breaking up big banks — will solve our problems. The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.

And the contrast between Texas and Georgia suggests that consumer protection is an essential element of reform. By all means, let’s limit the power of the big banks. But if we don’t also protect consumers from predatory lending, there are plenty of smaller players — both small banks and the nonbank “mortgage originators” responsible for many of the worst subprime abuses — that will step in and fill the gap.

Thus, on one side, Krugman readily support policies of inflation and having the Federal Reserve System artificially hold down interest rates. In other words, Krugman believes our government actively should push easy money.

However, on the other hand, he also wants government to determine who receives the new money through aggressive regulation. To put it another way, he wants the government simultaneously to make water flow downhill and uphill at the same time. That dog won't hunt, people.

Krugman seems to be the last economist who does not understand the "Capture Theory of Regulation," which was established long ago in the formal and informal economics literature. Instead, Krugman wants us to believe that as long as the regulatory offices are filled with "smart and well-meaning" apostles of financial regulation, then everything will be fine.

To put it another way, he believes that the same government (or at least government run by experts like him) that turns on the inflation spigots also is so wise that it can tell us exactly where that inflation should be direction, thus bringing happiness and prosperity to all. I don't think so.

All this reminds me of some parents in Chattanooga who rented a racetrack for their children to have a wild party after graduation. Their justification was that the kids were going to be drinking, anyway, so at least they could "regulate" the fallout from the party.

So, while their kids were getting stinkin' drunk, the parents patted themselves on the back for keeping their children from driving afterward. Likewise, Krugman believes that the government should supply Wall Street with endless amounts of financial "liquor," but that the regulators will keep everyone from getting drunk.

...inflation is an important tool in getting us out of this mess. It's painful and unfair--those who have been responsible and saved money will pay the price for those who borrowed money, racked up huge debts, and spent more than they could afford. But it's what the Fed is (quietly) aiming for.

The accompanying video further enhances the madness that we are seeing. Listen to what these people are claiming -- that the raising of interest rates by the Federal Reserve in 1937 was a huge error -- and realize that they are giving a truncated and perverse history of what happened in the 1930s.

What is especially chilling is the cavalier way that they dismiss savers and people on fixed incomes. Since Krugman already has declared savers to be partly responsible for our economic mess, my sense is that we are going to see responsible people demonized even more.

No society ever in human history has managed to inflate its way out of an economic crisis. People forget the crises that occurred in the 1970s precisely because the government had resorted to the printing press. It looks as though we are going to head for another repeat of that sorry decades, except what is going to happen is going to be much worse than what was going on nearly 40 years ago.

Thanks, Krugman. You receive a Nobel Prize and use it to promote the worst of "crankdom."

Friday, April 9, 2010

As I have said before, I appreciate Paul Krugman's openness in explaining his Keynesian views. True, he gives a few platitudes toward fiscal responsibility, but basically he recommends that government spend lots and lots of borrowed and printed money, and by doing so, will bring about economic recovery and prosperity.

The problem is not Krugman's saying such things; it's a semi-free country, after all. No, the problem is that when government follows these recommendations, disaster follows, even while Krugman and others are denying it or blaming the free market and sound money for economic evils. In today's column, he gives us more of the same.

As everyone knows, the government of Greece is in deep trouble. It overspent, went into deep debt, and now cannot pay back the debts. Even Krugman recognizes that fact, but then (as usual) draws the false conclusion that the way to deal with financial irresponsibility is, well, to be even more irresponsible:

Yes, Greece is paying the price for past fiscal irresponsibility. Yet that’s by no means the whole story. The Greek tragedy also illustrates the extreme danger posed by a deflationary monetary policy. And that’s a lesson one hopes American policy makers will take to heart.

Now, to say that any country now has a "deflationary monetary policy" is to be hallucinating. No one, I repeat, no one is engaging in deflation. Would be that were the case.

Here is Krugman in his own words about the crisis:

The key thing to understand about Greece’s predicament is that it’s not just a matter of excessive debt. Greece’s public debt, at 113 percent of G.D.P., is indeed high, but other countries have dealt with similar levels of debt without crisis. For example, in 1946, the United States, having just emerged from World War II, had federal debt equal to 122 percent of G.D.P. Yet investors were relaxed, and rightly so: Over the next decade the ratio of U.S. debt to G.D.P. was cut nearly in half, easing any concerns people might have had about our ability to pay what we owed. And debt as a percentage of G.D.P. continued to fall in the decades that followed, hitting a low of 33 percent in 1981.

So how did the U.S. government manage to pay off its wartime debt? Actually, it didn’t. At the end of 1946, the federal government owed $271 billion; by the end of 1956 that figure had risen slightly, to $274 billion. The ratio of debt to G.D.P. fell not because debt went down, but because G.D.P. went up, roughly doubling in dollar terms over the course of a decade. The rise in G.D.P. in dollar terms was almost equally the result of economic growth and inflation, with both real G.D.P. and the overall level of prices rising about 40 percent from 1946 to 1956.

Unfortunately, Greece can’t expect a similar performance. Why? Because of the euro.

Until recently, being a member of the euro zone seemed like a good thing for Greece, bringing with it cheap loans and large inflows of capital. But those capital inflows also led to inflation — and when the music stopped, Greece found itself with costs and prices way out of line with Europe’s big economies. Over time, Greek prices will have to come back down. And that means that unlike postwar America, which inflated away part of its debt, Greece will see its debt burden worsened by deflation.

Once again, Krugman gets it wrong. The USA followed pro-growth policies after World War II, unlike Greece (you know, where people actually are allowed to produce real goods without the government trying to put them out of business). However, Krugman, while admitting that Greece is not going to be so fortunate, then blames the semblance of sound money.

Like most Keynesians, Krugman believes a boom can last forever, just as long as government provides lots and lots of money, even if it leads to, well, double-digit (and worse) inflation. According to Krugman, the worst thing that can happen is deflation, and the real lesson here is that we need to debase the currency even more. Read on:

But what are the lessons for America? Of course, we should be fiscally responsible. What that means, however, is taking on the big long-term issues, above all health costs — not grandstanding and penny-pinching over short-term spending to help a distressed economy.

Equally important, however, we need to steer clear of deflation, or even excessively low inflation (Emphasis mine).

While Krugman does not define "excessively low inflation," nonetheless his point is clear. We need lots and lots of inflation, and anything else will be a disaster.

This is foolish advice, and it does not surprise me to read such nonsense from a Keynesian. After all, Keynesians believe that money is nothing more than a quantity variable that is to be manipulated to make aggregate models "work better." Is there unemployment? No problem; just add inflation, which will increase "aggregate demand" (because the demand for money falls as it loses value and velocity increases) and result in "full employment."

You see, to a Keynesian, this trick can be repeated time and again, as there are no real consequences from higher inflation except that prices go up. However, as Austrians point out, when inflation continues, malinvestments distort the structure of production, changing relative values of assets and ultimately leading to a crisis.

For example, contra Krugman, the housing boom could not continue because ultimately the factor prices in housing relative to everything else became too distorted to continue the charade. When the whole market depends upon being able to cram family incomes of $50K into paying a mortgage for a $500K house, the system cannot be sustained no matter how much new money government throws into the mix. Even Krugman recognizes that the housing market went bad, but then he reasons that it came about because of a lack of regulation, not because government was holding down interest rates and trying to direct that new money into housing. As I wrote in this post, such notions make no sense at all.

As I have stated many times before, the central problem is that Krugman and the Keynesians work from models in which all capital and all other assets are homogeneous. There can be no distortions in the structure of production, which always responds negatively to deflation and positively to inflation. This is a methodology that appeals to politicians and the modern, mainstream media, but it is not economics; it is Harry Potter Science.

Furthermore, we need deflation. That's right, far from avoiding it, we need to experience it. Yes, the initial results will be very painful (as though we are not experiencing pain now), but soon enough the factors of production will become balanced again, relative prices will make sense, and then the economy can find new lines of production that actually can be sustained.

However, because the initial stages of deflation are painful, Krugman says me must avoid it at all costs, even to the cost of destroying our money via inflation. Now, Krugman also believes that deflation will lead to a permanent downward spiral in which the economy ultimately becomes stuck at low production and high unemployment.

That is not true, not by a long shot. If Krugman were right, then the economy never would have recovered in 1982, when President Ronald Reagan and Fed Chairman Paul Volcker (who is the real hero here) permitted interest rates to rise, yet we had a real recovery in 1983 and beyond. While Krugman tries to claim that the recovery came about because of Keynesian-inspired deficit spending, the real results of that recovery contradict his story.

Had it been a "Keynesian recovery" (which in Austrian terms is an oxymoron), we would have seen growth in the usual sectors of manufacturing instead of seeing the growth centered on high-technology and telecommunications. Furthermore, Keynesians hold that one cannot have a recovery and have high interest rates, yet that is exactly what happened in the mid-1980s.

I agree with Krugman that the fact that Greece is on the Euro means that the government cannot inflate its way out of this mess -- and create a bigger mess. Yes, that means some real pain in the short run, but, contrary to what Krugman is claiming, in the long run it actually presents the Greeks with the opportunity to get things right.

Yes, there is a lesson from the fall of Greece. It is this: get your house in order and keep it in order. Don't keep printing money and claiming you are "saving the economy." Inflation is like heroin. It might feel good at the beginning stages, but in the end it destroys everything.

Wednesday, April 7, 2010

As predicted, many of the comments to my Austrian economics post are of the form “Well, of course employment rises when investment is expanding, and falls when the investment is falling — in the first case the economy is booming while in the second it’s slumping.”

As I tried to explain, however, that’s assuming the conclusion; there’s no “of course” about it. Why do periods when the economy is investing more correspond to booms, while periods when it’s investing less correspond to slumps? That’s easy to understand in Keynesian terms — but the whole Austrian claim is that they’re an alternative to Keynesianism. Yet I have never seen a clear explanation of this central point.

Actually, Austrians have explained this issue, but Krugman is not going to listen, and his way to argue is to create a straw man and then claim it is the real thing. The thing to keep in mind is that during a boom, there is malinvestment going on, not "more investment." There is a huge difference.

Austrians are saying that when government artificially holds down interest rates (something Krugman supports), investments are moved into areas that correspond well to the change in time preferences that are reflected when interest rates fall in a free market, due to increases in savings. However, when the government engages in artificially lowering the rates, then the investments do not match the spending patterns of consumers, and ultimately a crisis occurs, followed by a bust.

Krugman, on the other hand, believes that it is good for government to hold down the rates, but then apply regulation to stop potential bubbles. Here he is in his own words:

But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance.

This is more telling -- and more contradictory to the Keynesian arguments than what Krugman will admit, for he is hinting that low interest rates can lead to a bubble, which is what Austrians would call malinvestments (or maybe malinvestments on steroids). However, he believes that government can head off such malinvestments through regulation.

This is very interesting, for on one hand, he claims that it is all aggregate demand, but on the other hand, he is saying that forcing down interest rates can have consequences if government does not try to regulate away the excesses. However, he cannot have it both ways. Indeed, he is accusing us of employing back-door Keynesianism, but then tries to do the same with Austrian theory.

In a blog posting today, Paul Krugman once again attacks Austrian Economics, using what I see as a series of non sequiturs, not to mention contradicting his own Keynesian beliefs. He declares:

My view is that the fatal flaw in Austrian economics is that it can’t explain unemployment — or, worse, that it thinks that it can explain unemployment, but is deluding itself. The Austrian view is that unemployment in a slump results from the difficulty of “adaptation of the structure of production” — workers are unemployed as resources are painfully transferred out of an overblown investment-goods sector back into production of consumption goods.

But this immediately raises the question, why isn’t there similar unemployment during the boom, as workers are transferred into investment goods production?

Krugman has wrongly attacked Austrian Economics before, using this same argument and then calling the Austrian Theory of the Business Cycle a "hangover theory." However, as Robert Murphy has explained, the ATBC is not a theory that claims that good times automatically must lead to bad times; instead, it is a theory that concentrates upon malinvestments that occur during and boom and must be liquidated.

Unfortunately, Krugman's claim that Austrians cannot explain why there should not be high unemployment during a boom (because assets are being pulled in a direction away from what consumers would prefer through their purchases) actually contradicts his own Keynesianism. Remember, under Keynesian theory, all factors, including labor, pretty much are homogeneous, so labor automatically would transfer into the booming sectors, and Krugman's so-called refutation is built upon an assumption that labor is fixed and cannot move elsewhere. This makes no sense at all, but, then Keynesianism is a crude theory that does not stand up to scrutiny.

Krugman goes on with yet another straw man argument:

I’ve asked this question repeatedly over the years, and all I get is one of two things: gobbledygook, or “but during the phase of rising investment, the economy is booming!”, which is of course circular. In practice, Austrians seem to be Keynesians during booms without knowing it; they realize that high demand produces a boom, but don’t realize that this contradicts their own theory of slumps.

Actually, Austrians have given clear answers, but Krugman does not want to hear them, resorting to insults instead. The article I listed earlier by Robert Murphy goes into rich detail in answering each of Krugman's points. Here he deals with Krugman and capital theory:

You can't understand Austrian business-cycle theory (ABCT) unless you first understand the Austrian view of the capital structure of the economy. In this article,I showed how Krugman was simply incapable of grasping ABCT because he lacks a rich enough model of capital. For those newcomers who are unfamiliar with ABCT, I strongly encourage you to read the fuller discussion in the hyperlinked article.

Here is another Murphy quote regarding why there would not be unemployment in other sectors:

On the other hand, other sectors don't need to contract, because (unlike the scenario of genuine savings) nobody is cutting back on consumption. This is precisely why the Fed-induced boom is unsustainable — real resources have not been released from consumer sectors in order to fuel the expansion of the capital sectors. Because modern economies are so complex, the charade can continue for a few years, with entrepreneurs cutting corners and "consuming capital" (i.e., postponing necessary replacement and maintenance on equipment) while both investment and consumer goods keep flowing out of the pipeline at increased rates. But the music eventually stops, since (after all) the Fed's printing of green pieces of paper doesn't really make a country wealthier. When the Fed "cuts interest rates" it isn't really creating more capital for businesses to borrow; it is instead distorting the signal that the market interest rate was trying to convey.

What Krugman fails to understand about booms is that they are not sustainable. The occur precisely because of malinvestments caused by government monetary (and sometimes fiscal) policies. Furthermore, government compounds the problem by trying to prop up the failed sectors, throwing good resources into a financial black hole, instead of permitting the failed sectors to be liquidated or transferred to other uses and to let the proper proportions of the economic fundamentals to get back into balance.

However, with Keynesians, because all factors of production are homogeneous, there is no need to get factors into balance, since they always are in balance, anyway. Thus, in the Keynesian view, we just need stimulus forever.

Now, there is one problem that Krugman has created for himself, and it is this: If factors of production behave the way he says they do, and if booms always can be sustained through government spending, then why are there financial bubbles? If there are no proportions that get out of balance, why could not the housing boom have gone on indefinitely? Krugman's theories simply cannot answer that question, except to say that capitalism is bad and needs to be regulated by government.

Tuesday, April 6, 2010

According to Paul Krugman "textbook economics" teaches that in a recession, it is the duty of government to spend. Thus, when Michael Barone writes that the recent federal "aid" to state government mainly benefited unionized government employees, Krugman and the New Republic are all over this point, despite the fact that Barone is correct.

Sine (sic) it's pretty clear that Barone does not understand the theory he's arguing against, let me sum it up. Keynesian economics suggests that, in a severe recession, the government wants to pump demand into the economy through deficit spending. The federal government does this in part through "automatic stabilizers" -- during a recession, the decline in income and profits decreases tax revenue, and the increased need for food stamps, jobless benefits and other programs increases. States, however, are required to balance their budgets. Since revenues are falling and expenditures rising automatically, this forces them to cut spending and/or raise taxes automatically just to stay level. In other words, state fiscal policy has a large pro-cyclical effect, deepening the recession. The states lay off police officers, and then those officers stop going out to eat, forcing the local restaurant to lay off waitresses. Etc.

The purpose of providing aid to state and local governments is to help soften the pro-cyclical effect. Even with that aid, state government jobs have decreased by 5%, and local government jobs by 4%, over the last year.

The ideal fiscal policy during a massive economic crisis would be to temporarily increase the number of government employees, in order to soak up some of the enormous slack in the labor market. Mainstream economists believe aid to state and local governments is one of the most efficient ways to stimulate the economy. (But -- a ha! -- many economists work for universities, which are part of the public sector, so obviously they're trying to pay off the public employee unions, too.)

Well, Houston, we have a problem. First, Barone clearly is NOT advocating "Hoovernomics," since Herbert Hoover was the first president in U.S. history to have the federal government massively intervene in a downturn. (Chait believes that Hoover was a True Believer in free markets and did nothing, which means he has not read Murray Rothbard's book, America's Great Depression. Not that he really cares about the truth, anyway.)

Second, Barone is correct. The "textbook economics" really is Keynesian "economics," and just because a textbook tells us that government can bring prosperity by spending lots of money does not make it so. Chait and Krugman are people who seem to believe that government can create wealth by printing money. Not so. (According to Keynesians, government prints money and then wealth magically appears, which really is something akin to Harry Potter, not reality.)

As for Krugman's other column, "Me and the Bubble," he makes the point that the government should both artificially hold down interest rates and then regulate where the new money is going.

This is most interesting. Why does government hold down interest rates below market levels unless it wishes to subsidize those economic entities that are substandard? Yet, regulation is supposed to prevent substandard investments. So, on one end, Krugman wants people who are not creditworthy to have credit, but he just does not want them to be able to use that credit anywhere. That does not compute.

Poor Paul Krugman is on the defensive again. The "haters" are out there, and they are accusing him of promoting a housing bubble. Krugman, of course, is innocent of such bad conduct. He gives only good advice.

Since Krugman's latest crusade has been "financial reform," some people are reminding the Great Man of some words he wrote in 2002 when he was predicting a double-dip recession. Here is the controversial "bubble" paragraph:

The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

I tend to agree with Krugman that he was not promoting such a bubble, but rather was saying that the only way to ratchet up the kind of spending that Keynesians believed would end the recession was for Greenspan to create a housing boom. However, the next paragraph demonstrates that even Krugman did not realize that a bubble really was possible:

Judging by Mr. Greenspan's remarkably cheerful recent testimony, he still thinks he can pull that off. But the Fed chairman's crystal ball has been cloudy lately; remember how he urged Congress to cut taxes to head off the risk of excessive budget surpluses? And a sober look at recent data is not encouraging.

Interestingly, Krugman attacks Bush for pushing a tax-rate cut even though one of the Keynesian "solutions" to a recession is for government to cut taxes. Well, I guess Keynesians are happy only when the proper political party does the cutting.

Unfortunately, Krugman really gets it wrong when he denies that the Federal Reserve System's practice of holding down interest rates to artificially-low levels was foolish policy. Again, Krugman in his own words:

But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance.

Here is the problem. The housing boom occurred not only because the government shoved interest rates down to ridiculously-low levels, but also because the government aggressively promoted policies of home ownership. Greenspan himself was pushing the kinds of interest-only, teaser-rate mortgages that ultimately exploded and triggered a wave of foreclosures.

The only kind of regulation that would have kept the housing bubble from happening was the regulation that violated the government's stated policies of promoting home ownership, not to mention dealing with the demands from the political Left that people be able to have "affordable housing." How Krugman thinks that we could have had effective regulation in this situation is beyond me.

Unfortunately, Krugman really is not capable of a serious thought when it comes to regulation. Instead, he depends upon the politically-infantile "Democrats are good regulators, Republicans don't believe in Regulation" nonsense. Economists such as the late George Stigler, Sam Pelzman, Robert Tollison, Gary Becker, and Bruce Yandle actually have done real work in regulation, and they approach the subject like adults.

Sunday, April 4, 2010

Paul Krugman lays out what I think is an interesting question in this post on his NYT blog: Is it inevitable that the financial system will be bailed out in a crisis? Krugman answers with a firm, yes. In his view, if the system is not tightly-regulated, then sooner or later investors will run off the cliff.

Thus, he reasons, it is better to have tight regulation and avoid failure altogether:

In a crisis, the financial system will be bailed out. That’s just a fact of life. So what we have to do is regulate the system to reduce the chances of crisis and the taxpayer costs when the bailout occurs.(emphasis Krugman's)

Here is the problem with his argument, as I see it. Regulation effectively creates a government-protected and enforced cartel. The financial system that ruled until the early 1980s was in danger of running aground because inflation was leading depositors to take their money from banks and put it elsewhere.

Furthermore, people can be glad there was an "elsewhere" in the financial system. Think where we would be economically had there not been investment bankers and others outside the banking cartel to help finance some of the most important high-tech ventures in our history.

Krugman's "solution" is to make everyone part of the cartel. And don't kid yourselves; what he is demanding is the formation of a financial cartel, and all of the evils that go with it. What Krugman refuses to admit is that the Federal Reserve System and government policies to push people into home ownership are what touched off this mess, and had the government not bailed out a number of the players, Wall Street would have had to pick up the pieces honestly, instead of what we see today.

Had bank regulations stayed the way that Krugman says they should have stayed, all of us would be much poorer today. It was not the fact that people were given more opportunities to engage in finance that touched off this meltdown. In the end, it was the Usual Suspects in Washington.

Friday, April 2, 2010

Paul Krugman's post today, "The Patient Is in Stable Condition," says absolutely nothing, but nonetheless we have to remember that Krugman has been saying almost nothing correct for many years. Thus, when he cites any statistic on unemployment, I always cringe:

That’s the message of today’s jobs report. The economy is clearly adding jobs, even once you adjust for Census hiring and February snow. But not fast enough to make a dent in mass unemployment.

Furthermore, while the report today is semi-positive, nonetheless I agree with Peter Schiff that the government's actions are such that no real recovery is possible, and that there is no greater cheerleader for this destruction than Paul Krugman.

Now that ObamaCare has become law, Paul Krugman now is agitating for "financial reform," once again creating straw men, giving us a picture of the regulatory history of finance that is not true, and proposing "solutions" that only will lead to more problems. Other than that, I guess he will offer sound advice.

On the surface, all of us can agree. The financial meltdown on Wall Street came about because huge numbers of "investments," hedge funds, and other financial devices were pyramided atop securitized mortgages, which were being sold as though they were gold, instead of the fools gold they really were. To many people, it was obvious that this whole scheme was unsustainable, and when it went down, it went down quickly and very hard.

(In 2006, when I was appealing a tax ruling on my house, I told an Allegany County tax board that the housing market was, in fact, a bubble that would burst violently. They laughed at me, and one person said, "We don't see that happening." I replied that it would -- and it did.)

It is not hard to see in hindsight what happened. However, Krugman and I disagree on a large number of particulars, and one of them is the role of regulation in this mess, and the other is, well, the role of regulation needed to fix it.

Now, I agree with most (but not all) of what he writes here:

It’s easy to see where concerns about banks that are “too big to fail” come from. In the face of financial crisis, the U.S. government provided cash and guarantees to financial institutions whose failure, it feared, might bring down the whole system. And the rescue operation was mainly focused on a handful of big players: A.I.G., Citigroup, Bank of America, and so on.

This rescue was necessary, but it put taxpayers on the hook for potentially large losses. And it also established a dangerous precedent: big financial institutions, we now know, will be bailed out in times of crisis. And this, it’s argued, will encourage even riskier behavior in the future, since executives at big banks will know that it’s heads they win, tails taxpayers lose. (Emphasis mine)

He is correct about the moral hazard in the system, but the bailout was not necessary; in fact, it has blocked the needed liquidation of bad assets in the system and it is preventing a recovery from happening. Here we see the huge gulf between the Keynesians (and Friedmanites, for that matter) and the Austrians.

To a Keynesian, all assets pretty much are homogeneous, and what really matters is spending. Consumption is little more than people "buying back the products they make" in order to keep the Circular Flow intact. Thus, throwing more money into the economy via borrowing and printing will keep the economy from falling into the pit of deflation and helping set the stage for a recovery. To a Keynesian, the worst thing that can happen in deflation, for it creates an endless downward spiral that ends at an "equilibrium" of high unemployment and hopelessness.

(Robert Murphy in his Politically Incorrect Guide to the Great Depression has a good commentary on this error. He points out that if this were true, then the Federal Reserve System's tightening of money in 1921 would have thrown the economy into a pit from which it would not have emerged. Instead, the economy soon afterward had a robust recovery.)

Austrians take a different tact. First, consumption is a purposeful activity, done by people to meet their needs and desires. Second, the basis of consumption is production; we consume because we produce, and we pay for consumption by exchanging what we have produced for those goods and services we need.

This implies that there is a balance within the economy that must be sustained. The housing meltdown came about because the go-go housing market could not continue, as the pouring of resources into housing pulled the entire system out of balance. Unfortunately, too many economists have claimed that the housing meltdown came about because housing prices fell (Martin Feldstein comes to mind here); no, prices fell because this market could not be sustained no matter how much money the government and the banks threw into it.

In other words, the Keynesians and Friedmanites have made the fundamental error of violating what Carl Menger called the Law of Cause and Effect. They have assumed that the effect really was the cause of the calamity. Furthermore, they continue to demand "solutions" that only prop up the malinvestments -- at the expense of the rest of the economy, the still-healthy portion that will not be healthy much longer if the government continues its path of borrowing, printing money, and propping up the bad investments.

I do agree with Krugman that the moral hazard problem is real, but I disagree with his proposed "solutions" that really only compound the problem. What he proposes is to bring back the banking regulations that existed from the New Deal to the early 1980s, and then putting the rest of the financial system under the same regulatory umbrella. In his view, cited elsewhere, "smart" and "well-meaning" regulators can take over from there and keep calamities from happening.

Before going further, I agree with Krugman that moral hazard was a huge problem and I also agree that under the current mentality that grips the system today, the bankers and financial barons invariably will be successful in asking for new money to clean up the mess they have made. However, Krugman also forgets that the establishment of the Fed in and of itself was a huge moral hazard. The original purpose of the central bank was to be a backstop that would provide newly-printed money to member banks in case of a run or a "panic," which occurred once in a while. The presence of the Fed sent a signal to the bankers that the government had their backs, and that problem continues to this day.

There is another issue I have noted before, and that is the difference between Krugman's view of where regulated banking stood in 1980 and the view of Austrians and others. According to Krugman, the banking cartel (which it really was) was doing just fine, but ideological Reaganites came in and undid the whole carefully and wisely-planned structure, all in the name of ideology. Then they created an entire shadow system, also done from ideology.

In a word, that view is nonsense. The banking cartel was losing capital because the government held down interest rates it could offer depositors even while inflation raged in double-digits. People sought other venues and found them. In the meantime, Michael Milken already was helping to finance ventures that the banks would not touch. (As Daniel Fischel notes in Payback, much of the recovery of the 1980s came from Milken's financing methods.)

As economists such as George Stigler and Sam Peltzman pointed out, regulation has the effect of offering protection to regulated firms, but also serving to keep out competitors. In other words, contra Krugman, regulation creates what in effect are government-sponsored cartels. From this, we see "Capture Theory" emerging, as the regulated industries and their government regulators form a tag team that operates to the benefit of the people in the system -- and against consumers.

The ultimate irony is that Krugman and others are demanding re-regulation as a form of "consumer protection," which clearly has not been the pattern of regulation. Krugman can deny this point, but he is the one who is wrong.

Krugman can provide this fantasy of regulation all he wants, and I am sure that plenty of people will believe it, but that does not change the fact that "Capture Theory" is real and provides a much stronger view of regulation than does Krugman's Keynesianism. The re-regulation he espouses not only will make the economy weaker (as it protects the current set of malinvestments), but it also sets the stage for crises in the future.

Instead, we need to abolish the government backstops altogether and stop this bailout foolishness, which only provides the economic agony we are experiencing. The problem is not "too big to fail" or "we need more regulation." No, what we need is to clear the moral hazard out of the system and let the economic assets move to their real values.

Thursday, April 1, 2010

I can tell that Paul Krugman is excited. FINALLY! The government is going to force real cost savings at what is supposedly at the end of life. See the video below and decide for yourself if Sarah Palin is the idiot (at least on this subject) that Krugman claims she is:

Here is a quote from Bernanke's speech (and the quote, historically speaking, is wrong):

It was in large part to improve the management of banking panics that the Federal Reserve was created in 1913. However, as Friedman and Schwartz discuss in some detail, in the early 1930s the Federal Reserve did not serve that function. The problem within the Fed was largely doctrinal: Fed officials appeared to subscribe to Treasury Secretary Andrew Mellon’s infamous ‘liquidationist’ thesis, that weeding out “weak” banks was a harsh but necessary prerequisite to the recovery of the banking system. Moreover, most of the failing banks were small banks (as opposed to what we would now call money-center banks) and not members of the Federal Reserve System. Thus the Fed saw no particular need to try to stem the panics.

Krugman then declares:

The point is that breaking up the big players, then saying that it’s OK to let banks fail because no one player is crucial to the system is not a solution.

Uh, this is a non sequitur (a favorite argumentation tool that Krugman uses time and again), and really is head-scratching. One of the arguments for breaking up large banks has been that if they are "too big to fail," then they need bailing out, which causes lots of problems.

However, Krugman goes on, even if we break up the banks and then make them "not to big to fail," nonetheless, we should bail out those banks, too. This does not compute, people. If we are supposed to bail out banks no matter how big they are, then the original doctrine of breaking up banks is unnecessary. (Actually, I don't subscribe to the "too big to fail" doctrine, but since Krugman does, I figured I would challenge him on his own ground.)

Throughout the speech, Bernanke acts as though the only player in this whole affair was the Federal Reserve System, as though President Herbert Hoover's massive interventions did not happen. (My guess is that Bernanke, like Krugman, believes that Krugman actually followed Andrew Mellon's "liquidation" advice and did nothing. That is not true, no matter how many times these guys claim it is.)

However, Bernanke saves the best for last. In his speech, he closes with this:

For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Bernanke is right, and even more right than he realizes. Indeed, the Fed's actions of holding down interest rates and fueling not only the stock market bubble of a decade ago, but also the disastrous housing bubble truly does demonstrate that "destabilizing" actions by central banks can bring financial calamity, and we are living that right now.

However, this is not what Bernanke means. No, he means that the Fed did not "inflate" enough from 1929 to 1933, and he would not make that "mistake" again. And he has not, and the calamity grows worse.

Unfortunately, the Austrian paradigm, while explaining this downturn perfectly, is not popular among the "elite" economists, who really want to believe that if they crank up the printing presses and borrow money until the cows come home, they can beat this downturn via government spending. That "solution" never has worked, and it never will work. Bernanke has done it again, just as his predecessors 80 years ago had done. And, just like his Fed forebears, he never will understand the damage he has done and will continue to do.

About Me

I teach economics at Frostburg State University in Frostburg, Maryland. We are located on the Allegheny Plateau, and we have cool summers and tough winters.
I am the single father of five children, four of them adopted from overseas and I have two grandchildren. My family and I are members of Faith Presbyterian Church (PCA).